DEFINITION of ‘Intrinsic Value’
The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money.
BREAKING DOWN ‘Intrinsic Value’
Value investors who follow fundamental analysis typically look at both qualitative (business model, governance and target market factors) and quantitative (ratios and financial statement analysis) aspects of a business to see if the business is currently out of favor with the market and is really worth much more than its current valuation. The discounted cash flow model is one commonly used valuation method used to determine a company’s intrinsic value. The discounted cash flow model takes into account a company’s free cash flow and weighted average cost of capital, which accounts for the time value of money.
Intrinsic Value of Options
The intrinsic value for call options is the difference between the underlying stock’s price and the strike price. Conversely, the intrinsic value for put options is the difference between the strike price and the underlying stock’s price. In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero. Intrinsic value and extrinsic value combine to make up the total value of an option’s price. The extrinsic value, or time value, takes into account the external factors that affect an option’s price, such as implied volatility and time value.
Intrinsic Value of Options Examples
Intrinsic value in options is the in-the-money portion of the option’s premium. For example, if a call options strike price is $15 and the underlying stock’s market price is at $25, then the intrinsic value of the call option is $10, or $25 – $15. Assume the option was purchased for $12, so the extrinsic value is $2, or $12 – $10. An option is usually never worth less than what an option holder can receive if the option is exercised.
On the other hand, assume an investor purchases a put option with a strike price of $20 for $5, when the underlying stock was trading at $16. Therefore, the intrinsic value of the put option is $4, or $20 – $16, and the extrinsic value is $1, or $5 – $4. Assume that instead of purchasing a put option with a strike price of $20, the investor purchases a put option with a strike price of $15 for 50 cents, when the underlying stock was trading at $16. Therefore, the intrinsic value would be $0 because the option is out of the money. However, the option still has value, which only comes from the extrinsic value, which is worth 50 cents.